Why Health Care Start-Ups Like Theranos Need Investing Expertise

The Silicon Valley start-ups that often grab headlines are typically in the Internet and consumer technology world. But there’s another part of start-up land that is also highly active: health-related technology, which includes biotech, health care services and medical devices.

Venture capitalists have been pouring money into health-related start-ups, with funding jumping 34 percent to $9.4 billion in 2014 from a year earlier, according to the National Venture Capital Association. What’s often left unsaid about these companies is that they behave very differently from the typical consumer start-up or business software company.

The health-related start-up sector has produced fewer unicorns, which are the private companies with $1 billion-plus valuations, largely because it takes a long time to develop new medical tests, drugs or insurance systems. Regulators often weigh in. Even if an idea behind a start-up is truly great, it’s bound to fail if the science doesn’t work out, if the regulators don’t like what they see, or if insurers and the government won’t pay for the product.

Bryan Roberts, a partner at the venture capital firm Venrock, knows the risks. He has been investing in health tech companies since 1997 and has put money into seven unicorn companies, including Illumina, Athenahealth and Intarcia Therapeutics. He also led the investment in the health care software company Castlight Health, which has seen its stock price fall by half since its initial public offering.

Mr. Roberts explained in an interview what makes the health tech space treacherous for investors, including the dangers of investing in a good story rather than in good science. Among the companies he discussed was Theranos, the blood-testing start-up valued at around $9 billion by investors, which recently made waves after a Wall Street Journal investigation raised questions about its technology.

Software and services companies that focus on improving health care costs and outcomes used to attract specialists because they were in a small, unloved space. These companies have historically been treacherous for a few reasons. The customers have no money. The people who pay for care are different than the people who get that care, so incentives aren’t aligned. The providers have no idea how much things cost. And there was historically not much technology adoption in the space. But that’s changing thanks to new regulations, changes to payment models and more technology adoption. More technology entrepreneurs and investors are going into the space.

Biotech and diagnostics companies continue to attract specialists because they depend on very technical evaluations like clinical trial success or failure. It’s also a large enough market to support specialists.

Q.

You are a proponent of start-ups in health care-related industries having industry experts on their boards. Why?

A.

Generally speaking, the entrepreneurs are trying something new, innovative and risky. You need people who can push and prod on the founder because, at the end of the day, the company needs to integrate their totally new approach with cleareyed realism about the industry they’re trying to change. That realism comes from industry experience. I think that a leading indicator of success is how a company integrates those two things

Q.

Theranos has recently been in the news. What are your thoughts on the start-up? (Mr. Roberts was not approached to invest, nor did he look to invest, in Theranos.)

A.

I was skeptical. The industry that Theranos is a part of has been commoditized. Those blood tests are run millions of times a year by two entrenched players, Laboratory Corporation of America and Quest Diagnostics, that have only single-digit net margins. So I didn’t want to be in at any price, especially at a $9 billion valuation. The company would need $2 billion to $3 billion in revenue just for me to break even on my investment. I don’t want to break even. No one wants to break even. I want to make money.

If you build a start-up that competes against entrenched competitors based largely on price, that’s a hard business for anyone. The problem with competing on price is that entrenched competitors are willing to lose money to put someone out of business and get rid of them. You want to enable something totally new. I didn’t think Theranos was something new.

Q.

What role does data play in these types of companies?

A.

Especially in biotech and diagnostics companies, you have to follow the scientific axiom of trust the data and nothing else. No company, whether it’s Theranos or anyone else, will escape that truth.

Most companies present or publish data in parallel to the Food and Drug Administration process because the F.D.A.’s review is often not public. If you get approval, you still want your analysis and data to be public because the F.D.A. hurdles for acceptance are different depending on whether you’re a therapeutic, a medical device or a diagnostic company.

Broadly speaking, medical professionals place peer-reviewed literature in high regard. And as an investor, I want to read things that show that a new product to be a substantial improvement over what is already happening.

Q.

Is there a takeaway from the Theranos situation for investors?

A.

I look at the puzzle pieces around the Theranos experience and I’m reminded of the danger of the echo chamber. When people hear things 10 times they assume them to be true, and it can make it seem less urgent to do your own research. It’s not just a lesson for this industry.